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Opportunities in small and mid caps

Small and medium-sized companies are one of the cornerstones of corporate Europe. They are major generators of growth and employment and include some of the Continent's most dynamic and exciting enterprises.

But, thanks to their low profile, this contribution is all too often understated. They are typically outside the major equity indices that define the mainstream for investors in Europe.

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The quoted universe of more than 5,000 companies is very large and varied. The value of the largest of these stocks extends up to $3bn, creating a market that rivals its US equivalent in size. Add to these the numerous unlisted businesses and the size and importance of this sector becomes even more notable.

The recent reaction to technology stocks has not helped in the short term. This setback was an unwelcome reminder of the risk, and the reward, investment in high growth sectors can entail. It has also temporarily undermined the demand for new equity issues, a popular means for private companies to raise capital on the stock market. However, technology, media and telecoms forms only 16% of the HSBC Smaller Companies Index, one of the most widely used benchmarks, which has little exposure to the troubled telecoms sector.

Concerns about risk and limited liquidity are inhibiting investors from taking a more positive view on smaller companies, but the impact of these issues has been exaggerated.

There is plenty of potential to make money by buying smaller companies, especially at a time when they are out of fashion. Given the enormous size of the investment universe, there is scope to add value by effective stock selection.

Such a large stock universe demands a rigorous and disciplined approach to identifying exciting growth areas and the most promising investment candidates. Valuation is important, but it needs to be matched by quality ' namely cash generation, strong market share, barriers to entry and financial strength.

Additionally, in sectoral terms, European small caps present a strong contrast to the MSCI Europe and other mainstream indices. Large sectors like banks, oils and telecoms are thinly represented, while manufacturing and technology are abundant.

Seeking out bargains is an exacting exercise for buy-side analysts and fund managers, involving a heavy programme of company visits. Separating the wheat from the chaff among companies requires the application of a demanding set of criteria to evaluate their strengths and weaknesses.

Relatively few sell-side analysts cover this area, although more are being attracted (perhaps with one eye on corporate opportunities). This could represent an important step in raising the profile of European smaller companies and in establishing them as an essential component of a balanced investment portfolio.